IBM Reaches for the Clouds, But Should You Take a Rain Check?

Shares of International Business Machines (NYSE:IBM) have been underperforming the market as of late. So far this year, the stock is down a fraction of a percent whereas the S&P 500 is up over 5 percent. This is despite some seemingly bullish events such as:

An endorsement from Warren Buffett, who has been buying the stock aggressively for his Berkshire Hathaway (NYSE:BRK.B).

A recent quarterly dividend hike from $0.95/share to $1.10/share.

Continued stock repurchases that have reduced the number of shares outstanding.

Then why is IBM underperforming, and should you buy it? IBM has been underperforming for a very simple reason: its sales and profits are declining. IBM’s sales peaked in 2011 at $107 billion, and it has been steadily declining ever since. Its 2012 revenue came in at $105 billion and 2013 revenue came in at $100 billion. With a 4 percent decline in first-quarter revenues, it appears as if 2014 revenues will come in at $96 billion or so.

Profits have fared a little better seeing as the company has been cutting costs and shifting its business toward cloud computing — which is a high margin business — and away from hardware, which is a low margin business. IBM’s management like to highlight the fact that its profits have been growing at a much faster pace than its revenues as it makes this transformation. As a result, the company’s income has risen year after year — even from 2008 to 2009 — before peaking in 2012. Its 2013 profits were only slightly lower than 2012 profits, but for all intents and purposes it was flat.

Furthermore, while profit growth has outpaced revenue growth, the company has been aggressively repurchasing its own shares, which meant that EPS growth was even faster. Management has been regularly repurchasing $10 – $13 billion worth of stock each year, and this has reduced the number of shares outstanding. So even while net income fell in 2013, it rose on a per-share basis.

So, through 2013 the company’s performance wasn’t spectacular, but it was steady. Furthermore, it seemed that the company was executing its plan to shift its business from low margin hardware to high margin cloud computing relatively well, and this meant that in a few years IBM’s margins would be higher and it would be growing its business relatively quickly.

However, the first-quarter of 2014 proved to be disappointing. The company reported 4 percent lower sales, and a 21 percent decline in net income. While this was in part due to a one-time expense, it is evident that IBM’s business has peaked, and it is now in decline. While bulls are writing this off as a one-time disappointment, it fits a larger pattern of decelerating growth to the point of negative growth. For this reason, I think that investors should consider selling.

However, it might not be so wise to sell now. The company’s second-quarter headline EPS number should give the stock a boost. It is not so much that the company’s business is improving, but the company reported a 1-time expense in the second-quarter of 2013 that should make this upcoming quarter’s results appear strong by comparison. (Investors should note that IBM is one of those companies that reports these so-called “one-time expenses” or “unusual expenses” fairly regularly to the point that it is best to simply ignore them from a longer-term perspective.) Furthermore, it also appears as if IBM shares can bounce technically. There is strong support in the low $180s at the 200 week moving average. I would consider buying the stock for a trade at around $182/share and selling it near $200/share.

But longer term, it seems that the company’s business is in decline. We can see this from the chart that is making a pattern that resembles an upside-down parabola. Furthermore, while the company is growing its cloud business, the hardware side of the business has been and will continue to be a drag on the company for many years. Thus, I think IBM makes for a poor long-term investment.

Disclosure: Ben Kramer-Miller has no position in IBM or in any of the stocks mentioned in this article.